Rama Krishna Vadlamudi October 28th, 2009

CONTENTS PAGES
I. EXECUTIVE SUMMARY 1 to 2

II. A DETAILED SYNOPSIS 3 to 12

1. Projections for the year 3
2. What has not been attempted? 4
3. Measures undertaken 4
4. Policy Developments in the pipeline 6
5. Financial Market Products 7
6. Impact of the Policy measures 9
7. RBI’s concerns 10
8. The controversy about raising HTM limit 12

I. EXECUTIVE SUMMARY

END OF THE ROAD FOR EASY MONETARY POLICY:

Reserve Bank of India had announced its second quarter review of its
Annual Policy, popularly known as Monetary Policy, on October 27th. The
highlights and impact of the policy document have been analyzed from a
MACRO perspective. The Reserve Bank of India Governor, D Subbarao, has
sent signals, in no uncertain terms, to the financial markets in India that the
RBI is serious about the withdrawal of its accommodative monetary policy.
As part of the first phase of reversal, the so-called EXIT STRATEGY, the RBI has
increased the Statutory Liquidity Ratio (SLR) to 25 per cent (from 24 per cent); increased
the standard assets provisioning needs of banks to commercial real estate sector (CRE)
from 0.4 per cent to one per cent; the limit for export credit refinancing facility is reduced
to 15 per cent from 50 per cent of eligible outstanding export credit; and the special term
repo facility given to scheduled commercial banks for funding to mutual funds, NBFCs,
etc, is withdrawn with immediate effect. RBI termed these steps as the first phase
reversal of its ‘unconventional’ measures it had undertaken after the collapse of Lehman
Brothers Inc in the middle of September last year.
It may be recalled that the after the collapse of Lehman Brothers Inc in the
middle of September 2008, RBI had undertaken a raft of measures between
September 2008 and the early part of January 2009 to restore confidence in the
financial markets, especially in the money markets. RBI has earned a lot of
respect from around the world for its bold and innovative measures in response
to the evolving situation in the country following the unfolding of global financial
crisis triggered by the sub-prime market in the US. Several measures undertaken
by the Reserve Bank since mid-September 2008 have augmented
actual/potential liquidity in the system on the aggregate by Rs.5,85,000 crore.
(We Indians show our mettle during times of crises. As they say, this is the end of
good times for all stakeholders in the economy.)

RBI has indicated that the country’s GDP growth will be around six per cent with
an upward bias for 2009-10. The inflation based on wholesale price index (WPI)
will be 6.5 per cent by the end of March 2010.

What is noteworthy in the second quarter review of its Annual Policy is the choice
of instruments used by the RBI to give clear signals of its ‘exit strategy’ to the
markets. While keeping the CRR, LAF-Repo and LAF-Reverse Repo rates
unchanged; it has chosen to increase SLR by 100 basis points to 25 per cent,
instead of the usual CRR (cash reserve ratio) at this point of time. However, it is
not clear why RBI has resorted to increasing SLR though it claims that the SLR
increase will not have any impact on the liquidity situation in the banking system
and it is part of the withdrawal of the so-called unconventional measures
undertaken by RBI after September 2008.

FINANCIAL MARKET PRODUCTS: Some praiseworthy decisions that are being

introduced/considered are the following: 1. Expanding the currency pairs in
currency futures trading from the existing US dollar-Indian Rupee to three other
pairs, namely, Euro-INR, Japanese Yen-INR and Pound Sterling-INR; 2.
Introduction of over-the-counter credit default swaps (OTC CDS); 3. Issuance of
final guidelines on repo in corporate bonds; 4. Launch of STRIPS (Separate
Trading for Registered Interest and Principal Securities) during this financial year;
5. Introduction of price-based auction in floating rate bonds (FRBs). The
introduction of these new financial products will have a salutary impact in the
financial markets. Already, we’ve a vibrant market in currency futures and
interest rate futures, though their success rate is questioned by some market
pundits.

OTHER MEASURES: 1. Henceforth, Liabilities under CBLO (collaterised

borrowing and lending obligation), a product of the Clearing Corporation of India
Limited (CCIL), will attract CRR; 2. Banks are, from now onwards, are free to
open bank branches in semi-urban and rural branches (tier 3 to 6 areas); 3. Risk
weights of banks’ exposure to NBFCs is linked to the credit rating assigned to
the NBFCs; 4. Banks have to maintain a total provisioning coverage ratio on their
Non Performing Assets (NPA) at a minimum of 70 per cent.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 2 of 12

One striking feature that stares at our face on the morning of October
28th, a day after the announcement of second quarter of RBI’s Annual
Policy, is the consensus view among the various leading business
newspapers of the day. All of them have pointed out their take on the
RBI’s review, as if in a well choreographed way, describing the policy
as: THE END OF EASY MONEY POLICY. This is the headline that
has splashed across all newspapers today. This pithily describes the
overall view of the RBI’s second quarter review.

The above executive summary details the various measures in a lucid

manner. Now let’s look at the policy initiatives, actions and the
implications of the review from various perspectives. This will be
dividend different sections – measures undertaken, what is not
touched, what is the rationale behind the moves and what is the
impact on various markets as detailed in the contents stated above.

1. PROJECTIONS FOR THE YEAR

The baseline projection for GDP growth for 2009-10 is placed at 6.0 per
cent with an upside bias

The baseline projection for WPI inflation at end-March 2010 is placed at

6.5 per cent with an upside bias

The indicative projection of money supply growth of 18.0 per cent set out
in July 2009 is revised downwards to 17.0 per cent

Aggregate deposits of scheduled commercial banks are projected to grow

by 18.0 per cent.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 3 of 12

 2. What has not been attempted?

Sometimes, it so happens, what is not said is more important than what is stated
publicly. The same is true of RBI’s second quarter review of Annual Policy. Let’s
look at issues where status quo is maintained:

 Bank rate is kept unchanged at six per cent

 CRR is kept unchanged at five per cent of Net Demand and Time
Liabilities (NDTL)
 Repo rate, under Liquidity Adjustment Facility, is kept unchanged at 4.75
per cent
 Reverse Repo rate, under Liquidity Adjustment Facility, is kept unchanged
at 3.25 per cent
 Presently, banks are permitted to hold statutory liquidity ratio (SLR)
securities up to 25 per cent of their demand and time liabilities (DTL) in the
‘held to maturity’ (HTM) category of investments. Now, RBI has decided to
keep HTM limit for SLR securities unchanged at 25 per cent of their
Demand and Time Liabilities. (See the last page to know the real reasons
on the rationale behind this entire controversy)
At this point of time, RBI felt that it was not prudent to raise any policy rates as
the growth is still fragile in the economy. In the current debate of growth versus
inflation, RBI seems to be communicating to the financial markets that it wants to
give more importance to growth in the economy until more data are made
available which would confirm that a robust and irreversible growth in the
economy is underway. RBI’s decision of keeping the policy rates intact has been
hailed by many experts.

3. Measures undertaken

As part of the first phase of reversal, the so-called EXIT STRATEGY, RBI
has undertaken the following measures in the quarterly review:

 The Statutory Liquidity Ratio (SLR) is increased from 24 to 25 per cent of

Net Demand and Time Liabilities (NDTL) with effect from November 7, 2009
as the liquidity situation remained comfortable. Scheduled Commercial
Banks are currently maintaining SLR investments at 27.6 per cent of their
NDTL, net of LAF collateral securities, and 30.4 per cent of NDTL, inclusive
of LAF collateral securities. As such, the increase in the SLR will not impact
the liquidity position of the banking system and credit to the private sector.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 4 of 12

 The limit for export credit refinancing facility is reduced to the pre-crisis level
of 15 per cent from 50 per cent of eligible outstanding export credit with
immediate effect

 The special refinance limit; and the special term repo facility given to
scheduled commercial banks for funding to mutual funds, NBFCs, etc, have
been withdrawn with immediate effect

Other measures undertaken:

 The collateralised borrowing and lending obligation (CBLO) liabilities of

scheduled banks were exempted from CRR prescription in order to develop
CBLO as a money market instrument. Volumes in the CBLO segment have
increased over the years, especially after the phasing out of the non-banks
from the inter-bank market. The daily average volume in the CBLO
segment, which was only Rs.6 crore in January 2003, is now over
Rs.60,000 crore. Since the objective of developing CBLO as a money
market instrument has been broadly achieved, it is proposed that:

Liabilities of scheduled banks arising from transactions in CBLO with

Clearing Corporation of India Ltd. (CCIL) will be subject to maintenance of
CRR with effect from the fortnight beginning November 21, 2009.

 The provisioning requirement for advances to the commercial real estate

sector classified as ‘standard assets’ is increased from the present level of
0.40 per cent to one per cent

 Domestic scheduled commercial banks are, from now onwards, are free to
open bank branches in semi-urban and rural branches (tier 3 to 6 areas as
identified in the Census 2001 with population up to 50,000) under general
permission

 Risk weights of banks’ exposure to Non Banking Financial Companies

engaged in infrastructure financing will henceforth be linked to the credit
rating assigned to such NBFCs by the external credit rating agencies.
Infrastructure NBFCs are entities which hold a minimum of 75 per cent of
their total assets for financing infrastructure projects.

 Banks have been advised to maintain a total provisioning coverage ratio of

70 per cent, including floating provisions, against their Non Performing
Assets (NPA). Banks should achieve this norm not later than end-
September 2010.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 5 of 12

 4. Policy Developments in the pipeline

While RBI has taken a slew of measures as part of its second quarter review of
Annual Policy, there are several issues that are being tackled separately. Some
of these issues are:

Priority Sector Lending Certificates (PSLCs):

The Committee on Financial Sector Reforms (Chairman: Dr. Raghuram G.

Rajan), inter alia, recommended introduction of priority sector lending certificates
(PSLCs) for purchase by banks for achieving the priority sector lending target.
According to the Committee’s recommendation, PSLCs would be issued by
registered lenders such as MFIs, NBFCs, co-operatives, and registered money
lenders for the amount of loans granted by them to the priority sector, and also
by banks for the amounts in excess of their stipulated priority sector lending
requirements. These certificates could be traded in the open market, and banks
having shortfall in meeting the priority sector lending targets could buy such
certificates and thus meet the priority sector lending norms.

The Committee further recommended that in the trading of PSLCs, the actual
loans would continue to remain on the books of the original lender unlike in
outright purchase of loan assets. However, the buyer bank would show the
amount in its priority sector lending requirements. The seller of PSLC, if it is a
bank, will take it off its priority sector lending requirements even though it will
continue to carry the loan on its books. It is now proposed to constitute a Working
Group to examine the issues involved in the introduction of priority sector lending
certificates and make suitable recommendations.

Introduction of Duration Gap Analysis for Asset Liability Management:

The Reserve Bank had issued guidelines on asset liability management in

February 1999, which, inter alia, covered aspects relating to interest rate risk
measurement. These guidelines to banks approached interest rate risk
measurement from the ‘earnings perspective’ using the traditional gap analysis
(TGA). To begin with, the TGA was considered as a suitable method to measure
interest rate risk.

The Reserve Bank had, however, indicated its intention to shift to modern
techniques of interest rate risk measurement such as duration gap analysis
(DGA), simulation and value-at-risk over a period of time, when banks acquire
sufficient expertise and sophistication in this regard. Since banks have gained
considerable experience in implementation of the TGA and have become familiar

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 6 of 12

with the application of the concept of duration/modified duration while applying
standardised duration method for measurement of interest rate risk in the trading
book, this is an opportune time for banks to adopt the DGA for management of
their interest rate risk. With this move, banks would migrate to the application of
the ‘economic value perspective’ to interest rate risk management. Accordingly, it
is proposed to issue detailed guidelines on the use of DGA for management of
interest rate risk by end-November 2009.

Liquidity Risk

The Annual Policy Statement of April 2009 proposed to place the draft circular on
liquidity risk management, as also the guidance note on “Liquidity Risk
Management” on the Reserve Bank’s website by mid-June 2009. This was
deferred. Keeping in view active discussions underway at the global level on
liquidity risk management as the BCBS is also in the process of enhancing the
modalities for adopting the integrating risk management system, it is now
proposed to issue a draft circular reflecting these changes by end-December
2009.

Stress Testing

The Annual Policy Statement of April 2009 proposed upgradation of the stress
testing guidelines once BCBS finalises the paper on ‘Principles for Sound Stress
Testing Practices and Supervision’. In this context, the guidelines issued to
banks in June 2007 are required to be enhanced in the light of the final paper
issued by BCBS and taking into account international work/initiatives in the area
of stress testing, particularly that being done by the IMF and the FSB. It is
proposed to issue guidelines to banks on stress testing by end-January 2010.

5. FINANCIAL MARKET PRODUCTS

One important aspect of this monetary policy is the introduction of a host of

financial market products in the country. Reserve Bank of India is
considered as highly conservative when it comes to introduction of new
financial products, be it derivatives or swaps.

Reserve Bank of India, in consultation with the Securities and Exchange

Board of India, has recently issued guidelines for exchange-traded interest
rate futures. Accordingly, National Stock Exchange launched interest rate
futures (IRFs) on August 31, 2009.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 7 of 12

 TO KNOW MORE ABOUT INTEREST RATE FUTURES, JUST CLICK:
http://www.scribd.com/doc/19236501/Interest-Rate-FuturesIRFVRK100NSE-launched-
IFRAn-Update28082009

Likewise, RBI and SEBI issued guidelines for exchange-traded currency

futures in India in August last year. Accordingly, three stock exchanges
were permitted to start trading in this derivative product.

TO KNOW MORE ABOUT CURRENCY FUTURES, JUST CLICK:

http://www.scribd.com/doc/21686968/Currency-Futures-in-India-status-Check-After-
One-Year-Vrk100-27102009

However, surprisingly, RBI has come out with new financial instruments
that are expected to be launched in the next few quarters. They are:

 Final guidelines on repo in corporate bonds will be issued by end-November

2009. Draft guidelines have already been issued.

 To introduce plain vanilla over the counter (OTC) single-name credit default
swaps (CDS) for corporate bonds for resident entities subject to appropriate
safeguards. To begin with, all CDS trades will be required to be reported to
a centralised trade reporting platform and in due course they will be brought
on a central clearing platform.

 At present, issuance of non-convertible debentures (NCDs) with maturity of

less than one year is not subjected to regulation by the SEBI or the
Government of India. Now it is decided that Reserve Bank may frame
regulations on issuance of NCDs with maturity of less than one year, as
they fall under the definition of ‘money market instruments’ of Chapter IIID
of the Reserve Bank of India (Amendment) Act, 2006. Accordingly, draft
guidelines are being formulated by RBI which will be placed on the Reserve
Bank’s website by end-November 2009 for comments/suggestions.

 Separate Trading for Registered Interest and Principal of Securities

(STRIPS): Banks will be permitted to strip/reconstitute eligible securities
held in their held to maturity (HTM)/available for sale (AFS)/held for trade
(HFT) portfolios. Accordingly,STRIPS will be launched, as scheduled,
during the current financial year

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 8 of 12

 The FRBs will henceforth be issued by way of ‘price-based’ auction as
against the earlier ‘spread-based’ auction. Accordingly:

floating rate bonds will be issued during the current financial year
depending upon the market conditions and market appetite.

 It is proposed to permit the three recognized stock exchanges to trade

currency futures in three more currency pairs namely, Euro-INR, Japanese
Yen-INR and Pound Sterling-INR; in addition to US Dollar-INR which has
already been permitted since the introduction of currency futures in
August 2008.

 Draft guidelines on Forex, Commodity and Freight Derivatives will be issued

by the end of November 2009 for wider dissemination and comments/views

6. IMPACT OF THE POLICY MEASURES

BOND MARKET:

The initial reaction in the bond market was positive as SLR was raised by 100
basis points to 25 per cent. As a result, the benchmark 10-year yield has
softened by up to 10 basis points and the closing yield was 7.34 per cent on the
announcement day. At this point of time, it is comforting to note that RBI has not
taken any policy measures to suck out liquidity from the banking system even
though RBI has clearly indicated that it would have to increase its policy rates at
some point of time in future. RBI seems to be giving more importance to continue
with the stimulus for GDP growth in the economy. As such, it has not undertaken
any key measures except raising the SLR. The biggest beneficiary of the SLR
increase will be the Government of India. Overall, the 10-year benchmark yield
may remain between 7.20 and 7.50 per cent in the next few months before any
further policy measures are undertaken by RBI.

EQUITY MARKET:

Equity market has reacted negatively to the RBI policy. As RBI has increased risk
weights for loans to commercial real estate sector, there was heavy selling in real
estate stocks. Bank stocks too reacted negatively as RBI has proposed to
increase the NPA loan coverage ratio to 70 per cent and banks have to achieve
this limit by September 2010. As suggested by existing data, it appears this
measure will severely impact banks like, State Bank of India, ICICI Bank and
Canara Bank whose coverage ratio at present is between 40 to 50 per cent.
However, there is a feeling in the market that RBI may dilute this norm in future
or may postpone the implementation of this policy action.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 9 of 12

Overall, rate sensitive sectors, like, automobiles, banks and real estate sector will
be negatively impacted by the monetary policy stance, which might turn hawkish
in the next few months depending on the inflationary pressures and other
aspects, like GDP growth and industrial production data. However, it should be
noted that the impact will be different from sector to sector and from company to
company. While impact on banking sector may be less (as they are expected to
maintain their net interest margins), debt-ridden real estate sector may be hit
more severely.

MONEY MARKET:

There was not much reaction in the money market after the RBI’s review. The
call money and CBLO rates have remained at the same levels as before.
However, going forward, there will be some impact. From next month onwards,
CBLO will be subjected to CRR and as such the volumes in the CBLO market
may get impacted in future. As of now, there is no change in CRR. However,
when the CRR is hiked, the money market rates will go up. Moreover, market will
react to the proposed regulations on one-year non-convertible debentures below
one year; issue of floating rate bonds; and introduction of final guidelines on repo
in corporate bonds. These developments are worth watching in the money
market going forward. Call money rates at present are between 3 and 3.30 per
cent.

CURRENCY MARKET:

The initial reaction in the forex markets was a bit positive for the rupee
appreciation. However, after the stock market indices started falling heavily, the
rupee began to depreciate and breached the 47 level and subsequently ended at
46.91 on Tuesday.

7. RBI’s CONCERNS

INFLATION: As inflation based on consumer price index is still in double digits,

RBI has expressed its concern about inflationary pressures. The present CPI
inflation is induced by supply side pressures and a weak monsoon exacerbated
by crop damage due to floods in certain parts of the country. There is not much
RBI can do to the supply side pressures. Taking every thing in to account, RBI
has given an inflation (WPI) target of 6.5 per cent by March 2010. Ironically, RBI
has not raised CRR even though it expects inflation to rise to 6.5 per cent in the
next five months from the present level of 1.2 per cent. The Governor’s
explanation is that he does not want to give any wrong signals to the economic
agents in the country as far as growth stimulus is concerned.

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 10 of 12

BANKS’ INVESTMENTS IN MUTUAL FUNDS: RBI is concerned about the
indirect flow of liquidity that is taking place from banking sector to the corporate
sector through the mutual fund route. For the quarter ended September 2009, the
banking sector had invested around Rs 1,60,000 crore in different mutual fund
schemes like income, liquid and money market. The mutual funds, in turn, are
understood to have lent this money to the commercial or corporate sector. Due to
regulatory arbitrage of taxes, banks have been investing in mutual fund products
substantially. There is a concern on the circularity of liquidity in the system.
Keeping this in view, RBI has advised banks to form governance norms for
governing their investments in mutual funds. Some pundits argue that mutual
funds should not be an outlet for banks to park their resources.

THE CURIOUS CASE OF ASSET PRICE INFLATION: One surprising element in

the policy document is the RBI’s observation on Asset Price Inflation. In the
policy review, RBI asserts that asset prices have risen sharply in the recent
period. It further claims that after showing some correction in the latter part of
2008 and early part of 2009, real estate prices have risen significantly in major
cities. The curious case here is that it has not given any specifics in this regard. It
is interesting to note that RBI’s policy documents are usually littered with
enormous data to buttress their arguments and opinions/views. But in the case of
this so-called asset price inflation, RBI is silent and has not given any data.

This entire analysis is meant to be politically correct! If

you want to know my real views on RBI’s actions and
inactions, please wait for a day or two and watch my
POLITICALLY INCORRECT, DIABOLICAL and EXPLOSIVE
ANALYSIS of RBI’s poor record of reining in inflationary
expectations in the economy and how RBI Governor is
acting as THE BEST MONEY MANAGER of the
Government of India…

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 11 of 12

 8. THE CONTROVERSY ABOUT RAISING THE HTM LIMIT
Since the middle of September 2009, the bond markets were agog with
rumours that RBI would increase the HTM – Held to Maturity – limit from
the existing 25 per cent of demand and time liabilities in order to
facilitate the government’s heavy borrowing programme. In its review,
RBI has given a very funny reason why it was not raising the HTM limit.

Interestingly, RBI has taken more than a month to express its

categorical view on raising HTM limit. In the meantime, bond market
witnessed some wild movements. The 10-year benchmark moved from
7.45 per cent yield in the first week of September 2009 to a low of 7.00
per cent in the third week of September 2009. After a few weeks of
euphoria about the impending RBI’s relaxation of HTM limit, the bond
market seems to have realized its folly and the yields started inching up
again with the 10-year benchmark government security yield hardening
to 7.50 per cent a day before the RBI’s second quarter review.

Is there any method in this madness? Why has the RBI taken more than
six weeks to give its categorical view after both the Governor and a
Deputy Governor had gone on record saying that the RBI was
considering raising of the HTM limit? Why has the RBI encouraged
unnecessary and highly avoidable speculation in the bond markets?

This is highly paradoxical on the part of RBI to actively stoke

speculative elements in the bond markets. Is this just a ruse by RBI to
facilitate Government’s heavy borrowing programme? And who has
benefited from this speculation? Is it the banks, primary dealers or
Government of India? May be, we would never know the answers for
this piquant situation.

Another interesting piece of information, readers would like to know is

that the RBI Governor boasts in his review that RBI has raised money at
an average cost of only 7.14 per cent (for Central Government’s
borrowing from April 1st up to October 26th, 2009) despite hefty and
record Government borrowing programme and the Governor further
claims that this average yield is lower than the average cost of 8.81 per
cent for the corresponding period of the previous year. Wow!

Rama Krishna Vadlamudi, MUMBAI. October 28th, 2009 Page 12 of 12